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Drivers of the financial crisis
Fragmented regulation in the US with near-banking institutions highly
leveraged
Complex and fragmented oversight of many Leverage of selected financial intermediaries pre-crisis
un/under-regulated businesses Tangible assets/Tangible Common Equity
Including
Regulators 66.1x off-balance
sheet
National FRB, OCC2, FDIC 36.7x
21.8x
Banks State FRB, States3 29.5 31.0
Financial 17.8
Thrift OTS2, FDIC Holdings Government Investment Commercial
regulated sponsored banks7 banks
States3 by FRB
Mortgage brokers enterprises6
(national/
States3 state
Consumer finance bank), OTS Funding profile of selected financial intermediaries pre-crisis
(thrift), or Short-term funding5 as % of total assets
Investment SEC, States3 SEC 70
advisors (largest 36
securities 11
SEC, FINRA, CFTC,
Securities firms)1
NFA, MSRB, States3
Government Investment Commercial
SEC, FINRA, sponsored banks7 banks
Insurers
States3 enterprises6
1 Until September 2008 when the last independent investment banks converted to Bank Holding Companies
2 Bank Regulators retain primary regulator responsibility for all products sold by banks and bank subsidiaries – which include equity, futures, etc.)
3 Specific regulatory agencies and functions differ by stat. States maintain primary oversight for the insurance industry and generally maintain some version of a financial services regulator
4 Estimated based on size of relevant securitized asset-baked security (ABS) pools, private ABS pools allocated to private intermediaries by asset size
5 Includes repos, capital market funding, all other short-term borrowing (e.g., commercial paper) and current portion of long-term debt
6 Examples of GSE include: Freddie Mac, Fannie Mae, Federal Home Loan Bank
7 Weighted average for 5 large broker dealers: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley
Nota: FRB – Federal Reserve Bank; OCC – Office of the Comptroller of the Currency; OTS – Office of Thrift Supervision; FDIC – Federal Deposit Insurance Corporation; SEC – Securities and Exchange Commission; FINRA – Financial Industry Regulatory Authority;
CFTC – Commodity Futures Trading Commission; NFA – National Futures association; MSRB - Municipal Securities Rulemaking Board 2
Source: SNL Financial; Federal Deposit Insurance Corporation; Securities Exchange Commission; McKinsey Global Institute
Drivers of the financial crisis
Real estate bubble burst caught highly leveraged institutions off-guard
Banks had been increasing leverage whilst Real Estate bubble … and financial institutions were hit by the crisis
affected valuation of sub-prime backed securities… according to the respective leverage ratios
Asset-to-equity ratio
Timeline of crisis casualties Assets/equity
30
Top-5 US IB* High
U.S. mortgage originators
Top-10 EU and credit insurance mono-
20 liners
Iberian banks**
10 100
Special Investment Vehicles
2002 3 4 5 6 7 Q3 08
Total Total
amount amount
Main actions Measures $bn Measures €bn
• Guarantee new senior unsecured debt issued 4,534 • Guarantee newly issued debt of banks (e.g., 2,738
by banks with up to 3 years of maturity France guarantees interbank loans of up to
Guarantee/
acquire debt • Acquire high-quality 3-month commercial 5-year maturity and Germany guarantees
papers issued by businesses interbank loans of up to 3-year maturity)
• Guarantee money market mutual funds
Recapitalize
• Acquire nonvoting common or preferred 664 • Acquire stake in banks directly and through 231
banks shares in publicly traded banks or senior debt state-owned companies
in non-publicly traded banks
• Raise deposit insurance coverage to N/A* • Raise minimum coverage to €100,000 per N/A*
Guarantee $250,000 depositor (in 2008)
deposits • Offer unlimited cover of non-interest-bearing
accounts
Purchase • Acquire troubled assets from banks 332 • Acquire troubled assets from banks 588**
troubled
assets
• Try to mitigate mortgage foreclosures N/A* • Restrict executive compensation N/A*
Other • Restrict executive compensation
initiatives • Try to recoup any losses incurred from the
Similar measures were taken In Portugal
program within 5 years
* Not applicable
** Includes all individual ad hoc measures not executed through direct intervention
Source: IMF (Fiscal Implications of the Global Economic and Financial Crisis); Commission of the European communities (State Aid Scoreboard); press clippings 5
Role of governments and regulators in response to the crisis
In addition to direct intervention, regulatory bodies developed specific
proposals to address key crisis drivers
2007 2009
1 Includes Credit Suisse, UBS, Deutsche Bank, Barclays, BNP Paribas, HSBC, Standard Chartered, Santander, Unicredit, BBVA, Societé Generele, RBS and Intesa SanPaolo
2 Core tier 1, which is permanent, absorbs losses, and gives issuer freedom on dividend payment; must form at least 50% of tier 1
Source: CEBS Committee of European Banking Supervisors; SNL Financial; Morgan Stanley; JP Morgan; Company data 7
Role of governments and regulators in response to the crisis
CDS and banking returns are back in line with historical levels,
following period of abnormal gains
300
200 1
100 2
0
Jul-07 Out-07 Jan-08 Abr-08 Jul-08 Out-08 Jan-09 Abr-09 Jul-09 Out-09 Jan-10 Abr-10
ROE3 for European and US banks, 1962-2008 EU banks Average RoE levels of “normal”
US banks banking industries like utilities,
Percent4
industry RoE retail, etc.
Detailed in the
following pages
Increased capital quality
Capital Deductions
require-
ments Higher weighting of assets
Mitigation of pro-cyclicality
Supervisory bodies
Consumer protection
9
Perspectives on future regulation – Capital requirements
All elements of the capital framework will change according
to “Basel III” consultation documents
40%
-40% Deferred tax
1.2 0.6
assets
5.3
Minority
1.0 1.0
interests
Spain: 0
Pension funds 0.1 0.2
Portugal: ~0.9
Investments in
Core tier Core tier Deduc- 0.6 (can reach
financial institutions 0.5
1 ratio 1 after tions ≥2.0 pp)
(including insurance)
deductions
Group capital ratio (%) Group capital ratio (%) However, in the
example group B
8.0 7.6 8.0 is more penalized
3.2 despite common
equity being more
Initial With deductions Initial With deductions available to
of capital from of capital from support risks
minority interests minority interests (group
distress)
Deduction Deduction
(subsidiary 1) = [1 - 75%]× 20% × 8% = 0.4% (subsidiary 1) = [1 - 25%]× 80% × 8% = 4.8%
Only three
countries in EU still
have wide-spread
defined benefit
pension funds
schemes in the Indicative estimated impact of Basel III on core capital (2009)
banking sector Percentage points
(Portugal, Finland Different pension
and France) fund regimes will
1.92 lead to a unlevelled
playing field,
particularly severe
in Portugal
0.88
Highly cyclical, very
conservative in
0.11 "bad times“
Portuguese banks
Note: Methodology= Equity incl. Retained earnings + Pension fund assets - Pension fund liabilities
Source: JP Morgan; Company information; Spanish Banking Association; CECA 13
Perspectives on future regulation – Capital requirements
The strategically sound bancassurance model will be penalized with
proposed regulation
Regulatory proposals will decrease attractiveness of … despite clear strategic and risk benefits of
investments in insurance companies … bancassurance model
105
75 19
Investment 12
(+16%)
Banks
25 top global
banks (40-45% 2,181
of industry
554
assets) 1,190 437
Universal
(+37%)
Banks
2,200
580
1,200 420-480
Total Eurozone Banks1 (35-40%%)
Current capital Capital Additional capital
requirements requirements due
with Basel III to new regulation2
1 Total equity for Eurozone banks of 1,200 bln euros as of Dec 31, 2008
(2014E)
2 After accounting for expected retained earnings and needs of capital to fund growth
Note: Considering the higher flexibility of investment banks to “off-load” assets from balance sheet vis-à-vis universal banks (mainly credit)
Source: JPMorgan; ECB; McKinsey & Company Financial Institutions Practice 15
Perspectives on future regulation –Liquidity management
Excessive discrimination among EU states in access to liquidity further
impacting cost of debt, constraining the real economy
Liquidity rules might induce a … which will impact markets with a concentration of small
fundamental shift in banking business… businesses in spite of positive experience during crisis
• Run-off rates are very demanding for Business size distribution by number
Corporate and Institutional deposits of employees* • Small businesses
2007, % of number of businesses with no access to
– 15% for unsecured funding by SME 100% 100% capital markets
>= 250 25% 40%
– 25% for unsecured funding by
Sovereign, Central Banks and Public
• Hurdles for banks
< 250 75% 60% to access ECB
Sector
liquidity lines
Portugal EU 27
– 75% for unsecured funding by
Corporate
BES deposits
Jan 07-Jun 09. CAGR • During the crisis
+7.25% BES was able to
• Link between lending and deposits will capture growth in
result in a fundamental shift in +2.70% the Corporate
banking business forcing a reduction sector deposits
on exposure to Corporate businesses SME Corporate
N.a.
Additional liquidity
-4.4%
required
…while facing competition from governments in funding… Short-term impact Medium-term
(cumulative impact)
Funding needs of Eurozone governments1
Bln Euros 1,331
1,130
Private credit needs will induce other less regulated
players to replace banks in fulfilling funding needs,
promoting a “shadow banking system”
2008/2009 2010/2011
1 Net actual and expected increase in nominal public debt 2007-2011 (EIU viewswire)
2 Assumes banks only raise 50% of the required amount of capital, which implies a ~13% simultaneous reduction in RWA; impact on GDP based on ECB elasticity estimates (10% decrease in loans implies a short-term GDP reduction of ~0.8% and long-term
correlative GDP reduction of 3.25%)
3 Government capital injected in banks in 2008 and 2009 18
Source: JP Morgan; ECB; EIU viewswire; McKinsey & Company Financial Institutions Practice
Perspectives on future regulation
New regulation will impact US and Europe asymmetrically
New regulation with limited … reflecting different leverage and funding structure of corporate
impact in US… entities
Corporate debt as a percentage of GDP
• Supervision is still in political
93%
discussion with intervention of
different areas and experts 45% x2.1
1 Banks for which Basel II applies (significant international exposure or relevant balance sheet) - ~50% of US banking sector assets
Source: Global Banking Pools; Bank of International Settlements 19
In summary...
• Burst of real estate bubble in US and selected European markets caught off-guard a set of highly
leveraged near-banking institutions and investment & wholesale banks. Decisive action by
governments, regulators and banks was effective in containing the contagion on the financial sector
• New regulatory wave with profound impact on industry profitability through stringent capital,
leverage, liquidity requirements, stricter scrutiny of risk management practices and compensation
• In particular, Southern European economies will be more penalized given a more fragmented business
fabric (with a smaller average turnover) that has fewer financing alternatives
• Economic funding needs will, given capital scarcity from banks, be fulfilled in the market by less
regulated entities/markets further jeopardizing objectives
• Paradoxically, Basel Committee new proposals will induce a severe credit and capital scarcity, strongly
impacting an already fragile economy further contributing to economic recession and unemployment
20